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Why Panic-Prone Emerging Markets Are Breaking Down In 2014

This is a guest post by Wolfgang Koester, chief executive and co-founder FiREapps, a provider of currency exposure management tools.

It wasn’t too long ago that emerging markets were seen as the saviors of the global economy. In 2009, when advanced economies’ gross domestic product (GDP) fell 3.43 percent, emerging market economies grew 3.1 percent. Capital poured in – from investors looking for the only place they could actually grow their money to multinational corporations investing directly in facilities and equipment.

But investors don’t invest in emerging markets like they do in developed markets. Capital rushes in when the economy is hot; when the economy cools, investors dump their local currency holdings. That leaves piles of devalued local currency which the central bank is hard-pressed to prop up. (In developed markets like the U.S., United Kingdom, Japan, in contrast, investors are more willing to hold on to the currency.)

A cooling economy is exacerbated by the fact that worry breeds panic, and panic breeds crisis. In the midst of the Great Depression, President Franklin D. Roosevelt said, “We have nothing to fear but fear itself.” Fear of weakening emerging market economies – and the panicked reactions that follow – is a bigger driver of currency depreciation than the weakness itself. It is irrational exuberance in reverse.

The single biggest selloff in emerging market currencies since ‘09

We’ve been seeing that phenomenon play out on the main stage for the past couple of weeks. The Argentine peso plummeted 15 percent in a single day (January 23rd); the “contagion” quickly spread to other emerging markets, including most prominently Turkey, South Africa, and Russia. It was what Bloomberg has dubbed “the single biggest sell off in emerging market currencies since 2009.”

Argentina – In January, the Argentine peso fell 23percent. The most dramatic peso depreciation since the country’s 2002 financial crisis was triggered by the central bank’s decision to stop intervening in the markets to maintain the peso’s value – intervention that was increasingly costly, draining the country’s foreign currency reserves.

Turkey – The Turkish lira fell 6 percent in January; at its low point, the lira was down 9 percent from January 1st. On January 28th, the Turkish central bank took action to brace the falling lira, raising its benchmark one-week lending rate for banks from 4.5 percent to 10 percent. The lira rallied, then gave up those gains, and then recovered slightly.

South Africa – The South African rand fell 7.5 percent in January, its weakest level since 2008. The currency continued to fall even after the central bank raised its benchmark interest rate to 5.5 percent from 5.0 percent – the first rate increase in almost six years.

Russia – In January, the Russian ruble fell 7 percent, hitting a five-year low. But unlike the central banks in Turkey and South Africa, which have raised interest rates in attempts to prop up their currencies, Russia’s central bank has maintained a hands-off approach.

Even where central banks have taken action to stem the depreciation, “success is not guaranteed,” as The Economist put it. Theoretically, higher rates compensate investors for the additional risk they take on investing in weakening economies. The fact that these currencies continue to depreciate demonstrates that investors are unconvinced that the interest rate hikes are enough.

Furthermore, higher interest rates can be a double-edged sword, leading to further economic slow-down. The Wall Street Journal put it well: “Although higher rates are supposed to entice investors to continue investing in emerging-market currencies, analysts said the toll the higher interest rates may take on the economic growth of those nations may be too high.”

Benoit Anne, global head of emerging-market strategy at Société Générale, summed up the situation: “Global emerging markets are now trading in full-blown panic mode.”

What is causing the panic?

A confluence of factors is causing the emerging market panic. The first is the pull-back of stimulus in the U.S. Since September 2012, the Federal Reserve has pumped massive amounts of liquidity ($85 billion at its highest) every month into the global market in what has come to be known as “quantitative easing.” In December 2013, outgoing Fed Chairman Ben Bernanke announced the beginning of tapering – a $10 billion reduction in monthly bond buying. On January 29th, the Fed announced that it would reduce its bond buying an additional $10 billion, to $65 billion a month.

Much of the capital that the Fed was infusing into the market through its bond buying flowed to emerging markets. With the Fed tapering off quantitative easing, that liquidity is drying up. In other words, no more easy money. And that means that growth in emerging markets will, in all likelihood, be both more expensive, and slower. Potentially, the slowdown could become a crisis. As Robert Kahn, a Senior Fellow at the Council on Foreign Relations (CFR) explains, “If you look at the long arc of past emerging market crises, a lot of them were triggered by a tightening of global monetary conditions.”

CFR has a wonderfully illustrative graphic in their recent backgrounder, Currency Crises in Emerging Markets, which shows how the Fed’s “taper talk” has affected emerging market currencies. In May 2013, when Bernanke, then Chairman of the Fed, told Congress that “[the Fed] could take a step down in the next two meetings,” the currencies of Russia, Mexico, South Africa, Turkey, Brazil, India, and Indonesia fell between 3 and 15 percent against the U.S. dollar. When Bernanke announced on September 18th that the Fed would not be rolling back its bond buying, the currencies of those same countries rose between 1 and 3 percent.

The second factor causing emerging market panic is this: at the same time that liquidity is drying up, the economies of many emerging markets are slowing. Many analysts believe that the current sell-off was precipitated by a report showing a slowdown in China. Bloomberg explained in a recent article, “Developing-nation currencies sold off after a report from HSBC Holdings Plc and Markit Economics indicated yesterday that China’s manufacturing may contract for the first time in six months, adding to concern that growth is losing momentum.”

China is not only the world’s largest emerging market economy, but it is also the chief buyer of exports from other emerging markets. A slowdown there spells bad economic news for many.

What it means for multinational companies

Both the tapering of stimulus in the U.S. and weakening of emerging market economies lead to currency volatility (clearly), which leads to panic, which leads to more volatility. What that means for U.S.-based multinationals is a stronger dollar, which means negative revenue impacts for the companies that don’t manage currency exposure across all currency pairs. Just as yen devaluation did in 2013, emerging market currency volatility will generate ripple effects through 2014.

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I can not count the number of Keynesian innumerate on comment boards claiming that none of the hot money from the FED is flowing to emerging markets. One even presented data showing the volume of printed money over time plotted with banks cash reserves. I should have challenged the moron because the two graphs had a correlation of 1.00…….that usually equals a lie. At any rate, the Keynesians making this delusional claim are now exposed as charlatans as their delusional narrative is flattened by reality (to assume the money would not flow to the higher yields is incompetence and inept). Liberals always have their delusional world view flattened by reality at some point. At any rate, don’t Keynesians have an ounce of integrity anywhere within them?